Trade deficits with China may be ‘horrible,’ but there are no quick fixes

Based on the numbers for the first nine months of this year, the U.S. deficit on goods trade with China is likely to hit what President Donald Trump called last week an “unmentionable,” “embarrassing,” “horrible” red ink trail of $370 billion. He may have intended to blast China, but that 6.3 percent annual increase in trade deficits has been happening on his watch.

China likened all that to an “unintentional” collateral damage caused by free markets. That’s an interesting retort, but it’s quite at odds with trade analysis. Beijing’s trade surplus with the U.S. was down 6.4 percent in 2016, even though American domestic spending (a variable that drives import demand) was growing at a rate roughly comparable to what we have seen so far this year.

It would have been simpler, and more accurate, for China to invoke its “win-win” mantra of friendly and peaceful international cooperation.

That win-win? In the first three quarters of this year, the U.S. won big with $91 billion in export sales to China — a 15 percent increase from the same period of 2016. The deal maker-in-chief coming to China on Wednesday would probably whisper to his trade experts: “That’s yuge.”

Who’s the ‘win-win’ winner?

But wait until Trump hears that those $91 billion in U.S. sales pale into insignificance compared to China’s $364.8 billion worth of goods unloaded in America since he took the helm last January. That is an 8.3 percent increase compared with the first nine months of 2016.

At that point, the Chinese, laughing all the way to the bank, would probably say: “Hey, you win some, and we win four times as much is still a ‘win-win’ deal.”

It sounds like they are asking, in New York vernacular, “What’s there not to like?”

A lot. China understands that this is an unsustainable trade relationship, but it is not in a hurry to correct structurally unbalanced trade flows with the U.S.

China’s former President Jiang Zemin used to ridicule international experts urging quick action in the early 1990s to restructure inefficient state-owned industries. More than 20 years on, that restructuring is still China’s work-in-progress under a fancy name of “supply-side reforms” — a puzzling thing for American economists thinking of the analogy with the Reagan era fiscal policies summed in an “optimal taxation curve” that Art Laffer drew on a paper napkin.

Trump is unlikely to fall for a slow-going trade adjustment process, but there is a real concern about what he can do to speed things up, particularly since vexing trade issues cannot be cleanly separated from America’s strategic interests where China looms large.

Some things should be clear, though. China’s “win-win” strategy can be read from the trade patterns observed so far this year: Allow, and even promote, an increase in U.S. exports to China in exchange for a liberal access to American markets for Chinese goods, services and direct investments. What China calls “two-way investments” is, in fact, a push for recycling its $150-$200 billion in annual current account surpluses to acquire technology and a broadening market presence in the U.S.

That is a tough negotiating gambit. Washington may wish to respond by emphasizing a rebalancing of trade flows. China should be welcome to keep buying the Treasury’s IOUs, but Wall Street can provide ample investment funds for America’s viable business ventures.

China’s greenfield investments in the U.S. are a different story. The Chinese would be bringing in their own capital, technology and managerial knowhow. In such cases, Washington should insist that the Chinese be allowed to operate in the U.S. under the same conditions required of American direct investors in China.

Beijing wrapping trade in a broader vision

Led by Germany’s export champions, the Europeans are showing what Washington may wish to consider. The European Union has already moved to limit both trade and China’s investments, arguing that they were simply responding to similar limitations the EU businesses are encountering in the Middle Kingdom. The thawing of the EU-China trade and investment regime could take a long time, even in the unlikely case that Germans agree on their new coalition government by the beginning of next year. That, of course, would strengthen the hand to American trade negotiators.

China is fully aware of those difficulties. Hence the temptation to package trade as part of Beijing’s lofty vision of great power relationships. That sounds like an exalted talk about how America and China can work together to build a global architecture of peace and economic prosperity — circumscribed by China’s red lines on its maritime borders, Korean Peninsula and internal issues where the Communist Party remains in charge of “socialism with Chinese characteristics.”

It will be interesting to see how Washington will respond to all that at the time when stopping and reversing its huge, and growing, trade deficits with China is a matter of great urgency. That would show whether the U.S. and China can establish trade mechanisms and procedures for an acceptable, and viable, agreement around their clashing red lines in Asia and in the rest of the world.

China is not sure; it is hedging its bets, just in case, and is working hard to reduce the American leverage on its strategically important issues. Here are a few examples.

Beijing is taking the lead for a peaceful resolution of the North Korean standoff. Passing that acute phase in the current crisis, the Chinese (and the Russians) are envisaging a gradual elimination of Pyongyang’s nuclear weapons and their medium- and long-range delivery vehicles — while drawing the North Koreans into the economic and political mainstream of the world community.

Using South Korea’s hugely important economic interests in China, Seoul was “convinced” to shelve (whatever that means) the American missile shield — an issue strongly opposed by Beijing. Last year, China took $124.4 billion of South Korean exports, nearly double the volume of sales to the U.S., and remained Seoul’s most important trade partner by far.

The Chinese media reports also have it that Seoul refused to participate in a trilateral military alliance with the U.S. and Japan.

China’s relations with Vietnam have improved considerably as well. Last week, the two countries pledged an “all-out cooperation,” and a state visit to Vietnam for the Chinese President Xi Jinping is set, after the APEC meeting, on November 12.

By contrast, relations with Japan remain a big problem. China is inviting Japan to use its newly minted two-thirds “super majority” in the Diet’s lower house to tread a friendlier course in the spirit of key political agreements since China and Japan normalized official ties in 1972. A long shot indeed.

Finally, to make sure the message is understood, China is warning the U.S. to stay out of the South China Sea territorial disputes, Chinese military installations are being built on contested islands and, sporting army fatigues, Xi was telling his armed forces last Friday “to improve their combat capability and readiness for war.” And that’s only a few days before Trump’s “state visit-plus.”

Investment thoughts

Trump has a tough visit to China. It is difficult to see how the solemn decorum — and probably a few big ticket deals — can lead to meaningful and sustainable progress in reducing America’s growing structural trade imbalances with China.

Apart from that, the U.S. and China positions with respect to the North Korean crisis and China’s maritime boundaries are totally opposite and outright hostile.

The only silver lining is the absence of military solutions to any of these issues. Barring accidents and reckless miscalculations, that offers a perspective of a grudgingly managed strategic rivalry.

Investors’ attention will, therefore, continue to focus on the new Fed leadership, and on China’s ability to maintain strong growth, a stable financial system and an increasing reliance on domestic spending and service sector industries.
Source: CNBC

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